What to do if your fund becomes subject to ERISA.

This article discusses, in general terms, certain of the ramifications under both the Employee Retirement Income Security Act of 1974, as amended (ERISA) and the prohibited transaction rules under Section 4975 of the Internal Revenue Code of 1986, as amended (the Code), to investment vehicles, such as hedge funds, that are deemed to hold "plan assets" under the US Department of Labor's (the Department) regulations as modified by ERISA section 3(42) (1) (Funds). A previous version of this article appeared in the June 2006 issue of The Investment Lawyer. This article has been updated to reflect recent developments in the law.

As ERISA's fiduciary standards and the prohibited transaction rules under both ERISA and the Code apply to fiduciaries, which is defined to include persons who have discretionary control or authority over plan assets or render investment advice for a fee with respect to plan assets, Fund investment managers and advisers become fiduciaries and subject to such provisions by reason of their advisory duties, where they are dealing with plan assets. As the Code contains prohibited transaction provisions that are substantially similar to those of ERISA, for the remainder of this article and unless provided otherwise, references to ERISA's prohibited transaction rules shall include the corresponding Code provisions.

Plan Assets

As ERISA applies a "functional" definition of who is a fiduciary, which turns on whether a person is dealing with "plan assets," much depends on identifying plan assets. The concept of "plan assets" is fairly complex and highly technical. Generally, the concept was developed to provide guidance as to when a plan investment constitutes an arrangement for the indirect provision of investment management services, as opposed to an investment in an entity with the purpose of generating profits through its operations. In other words, this provides a "look-through" rule for applying ERISA to certain entities that are not themselves employee benefit plans. If an entity is deemed to hold plan assets, each ERISA plan (or plan within the meaning of Code section 4975) that invests in such entity is deemed to hold an undivided interest in its underlying assets, and the managers of the entity generally will be considered fiduciaries for purposes of applying the prohibition transaction rules and ERISA's fiduciary requirements.

First, ERISA section 401(b)(1) provides that where a plan invests in securities issued by investment companies registered under the Investment Company Act of 1940, as amended (1940 Act) the assets of the plan include such securities but not the assets of the investment company. Second, ERISA section 401(b)(2) provides that plan assets include a plan's investment in certain types of insurance contracts but not the assets of the insurer. By negative implication, other entities that are not specifically carved out by the statute do hold plan assets.

To clarify the definition of plan assets and provide guidance as to how to identify entities that hold plan assets, the Department adopted its "plan assets regulation." As stated in the preamble to the plan assets regulation, the regulation "reflect[s] a general policy determination that the fiduciary responsibility provisions of [ERISA] should apply to an entity in which a plan invests only if: (1) the plan's investment is such that it has an opportunity to participate in the earnings of the entity; (2) the entity itself is an investment fund; and (3) there is some indication that interests in the entity are offered especially to plans." (2)

As noted, the "plan assets" concept is a look-through rule. The plan assets regulation provides that an entity will be deemed to hold plan assets if:

* The plan's investment is an "equity interest;"

* The investment is not a "publicly-offered security;"

* The issuer is not registered as an investment company under the 1940 Act;

* The issuer is not an "operating company;" and

* Equity participation by "benefit plan investors" is "significant."

Although some unregistered investment funds, such as private equity and real estate funds, can avoid being deemed to hold plan assets by qualifying as special types of operating companies under the plan assets regulation, known as VCOCs for "venture capital operating companies" or REOCs for "real estate operating companies," which each require a certain level of management authority over their portfolio investments, most unregistered funds that avoid holding plan assets do so by ensuring that participation by benefit plan investors remains insignificant. In short, the plan asset regulation provides that participation by benefit plan investors is not significant where benefit plan investors own less than 25 percent in value of each class of equity interest in the investment fund (the so-called 25 percent rule). Shares owned by the fund's investment manager, adviser, or any affiliate thereof (or any other person with discretionary authority or control over the investment of the fund's assets or a person who provides the fund investment advice for a fee) are disregarded from such calculation. The calculation is done each time fund shares are issued or redeemed.

As so much depends on how the 25 percent rule is calculated, Congress, after much lobbying, stepped in to clarify the rule. The Pension Protection Act of 2006 (PPA), enacted August 17, 2006, adds section 3(42) to ERISA in order to modify the Department's plan asset regulation. Specifically, ERISA section 3(42) redefines "benefit plan investor" to include only

1. ERISA covered employee benefit plans,

2. Tax-qualified retirement plans and accounts (such as KEOGH plans and IRAs) that are subject to the Code's prohibited transaction rules and

3. Other entities (such as a hedge funds or a feeder fund in a master-feeder structure) whose underlying assets are deemed to be plan assets under the plan asset regulation as modified by ERISA section 3(42) (collectively, ERISA/ Code plans).

The significance of the change is in what the term "benefit plan investor" no longer includes. Specifically, prior to the enactment of ERISA section 3(42), the term "benefit plan investor" for purposes of the plan asset regulation included in addition to ERISA/Code plans, retirement plans neither covered by ERISA nor subject to the Code's prohibited transaction rules, such as governmental, foreign and non-electing church plans. As these non-ERISA/Code plans are no longer considered benefit plan investors, their investments are no long aggregated with the investments of the ERISA/Code for purposes of calculating the 25 percent rule, resulting in greater capacity for funds choosing to remain under the 25 percent rule.

The PPA also clarifies that in the context of a fund of funds, master-feeder or other situation where one private investment fund …